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Last week, the U.S. Treasury market spit out a historically reliable signal that the next recession is on the horizon: The yield on the 10-year Treasury note fell below the one for the 2-year Treasury, causing an inverted yield curve. Also troubling is that the yield on the 30-year bond fell to an all-time low. That means investors believe economic growth will falter and interest rates are headed lower.
“Are we heading for a recession? Will we eventually have one? Yes, of course. The question is, will it be within the next year, or year and a half?” said Jeremy Siegel, Wharton finance professor and markets expert, on the Knowledge@Wharton show on SiriusXM. “Right now, outside of the [signal from the] yield curve, there are no real signs that we’re heading for a recession.”
Siegel is in good company. Former Fed Chair Janet Yellen recently said the inversion may be a “less good signal” now of a recession. She also doesn’t think the next recession is coming, although “the odds have clearly risen and they’re higher than I’m frankly comfortable with.” Siegel said most market experts he follows put the odds of a 2020 recession at one in three or a little bit higher.
Meanwhile, the stock market remains spooked by fears of an economic slowdown as the U.S.-China trade wars continue. “If there’s no agreement on the trade [talks] and there’s still threats of 10% and … 25% [tariffs], I see no progress in the stock market for the year end,” Siegel said. “In fact, I would say it could be lower.” But if the U.S. and China get a trade deal, “we’d be up 10% to 15% from where we are today.”
“Right now, outside of the [signal from the] yield curve, there are no real signs that we’re heading for a recession.”
Demographics and Lower Rates
A headwind to those market hopes is the inverted yield curve. “Is that inversion worrisome?” Siegel postulated. “There is no question that when the long-term interest rate goes below the short-term interest rate, that has been, in the past, an extraordinarily reliable indicator of a coming recession.” Historically, he added, there’s only been one time in the late 1960s when an inverted yield curve did not lead to a recession.
What’s different today is that other factors are helping to lower rates, “which may make it less threatening this time than in the past,” Siegel said. These are “fundamental factors that go far beyond what central banks in the world are doing today.” He cited changes in demographics, such as an aging workforce and longer life expectancies that push people into saving more.
As they age, many buy bonds because these are considered safer and less volatile than stocks. “When things are bad, when you see the stock market down 1,000 points or whatever, you will see Treasury bonds jump up in price,” Siegel said. “Whenever you have an asset that moves [in the] opposite [direction as] stocks … they become very desirable in investor portfolios because they lessen the risk.” Long-term U.S. Treasuries in particular have become the “hedge asset of choice,” he added.
Since there’s only “so much supply [of bonds, demand] is driving up their price and lowering rates,” Siegel said. “What we have now is a tremendous number of people piling into these bonds, not because they think the yield is good. The yield is not good.” It’s because they believe U.S. government bonds offer more security relative to other assets. “Never before, at least in post-World War II history, has the Treasury bond ever served better as such a risk diversifier as it does today,” he added.
With this demand for bonds helping to push long-term interest rates down, the current yield curve inversion is “less threatening than in the past,” Siegel said. So if this recession signal is less reliable now, should the Fed even be considering lowering the Fed Funds Rate, a key short-term interest rate, at its next meeting in September as the market expects? “I actually think they should be moving the Fed Funds Rate down 50 basis points,” he said.
“Whenever you have an asset that moves [in the] opposite [direction as] stocks … they become very desirable in investor portfolios because they lessen the risk.”
For one, “it is normal for the short-term rate to be below the long-term rate,” Siegel said. Also, the U.S. is at odds with other mature economies. Currently, the Fed set the target for the rate, which influences what banks pay on deposits and rates on loans, among others, at 2% to 2.25%. “Right now at 2.15%, that’s the highest rate in the developed world for any maturity” of government debt, Siegel said.
Globally, low interest rates have led to negative yields for nearly all the 10-year bonds in Europe. For example, the 10-year German bond is yielding negative 0.7% compared to 1.6% for the 10-year U.S. note — a big gap. That means investors looking for a place to park their money will find U.S. yields more attractive. “People have been moving from Europe to the U.S.,” Siegel said.
Slowdown, Not a Recession
Siegel doesn’t see a recession coming in the near term, but “I definitely think we are in a slowdown.” (A recession is marked by declines in real GDP. A slowdown means the economy is still growing, but at a reduced rate.) He said most experts he follows believe third quarter GDP will come in at around 2%. “Last year, we had 3%, and revised down to 2.5%,” Siegel added. “We are in a slowdown and many people believe that if the Trump trade wars continue, [GDP growth] is going to fall into the 1 [percent range.] So it seems reasonable to me for the Federal Reserve to provide an insurance policy and a boost here” by cutting rates.
Some might believe that since the last recession began more than 10 years ago, the U.S. might be due for another one soon. But Siegel said there is no set cycle for when recessions occur. He pointed out that Australia didn’t have a recession for 20 years and Great Britain had an economic expansion that lasted nearly as long. “It’s not necessarily that we’re due for one any time,” Siegel said. “We have the potential I think if we don’t mess up policy to keep this expansion going for three or four years.”
Moreover, this current economic expansion that began a decade ago was “very disappointing in terms of the GDP rebound,” Siegel said. The average GDP the U.S. achieved was 2% when historically the norm has been around 3% or 3.5%. While the Trump tax cuts and regulatory loosening helped a bit, “now we’re sinking right back down and maybe even a little lower than the average we got during the Obama administration.”
“GDP growth has been disappointing because productivity growth has been disappointing,” Siegel continued. “When productivity growth is disappointing, real wage growth is disappointing — and it has been … the slowest real wage growth in any recovery.” However, consumers have continued spending and are “actually carrying the economy in 2019.” He noted that consumer spending drives two-thirds of the U.S. economy. And while consumer sentiment has dipped, it has not decline “seriously,” Siegel said.
Rather “where we really see a slowdown and what people fear might get worse — if there’s more tariff escalation — is business spending” weakening, Siegel said. “A lot of businesses are saying, ‘I don’t know which way these tariffs are going to go, I’m putting off my decision [to expand]. Economists are more worried that capital spending is going to be the initiator of the next recession, if we have one.” But if consumer sentiment dives too, there’s very little the U.S. can do to “save ourselves from a recession.”